Why I Went From Bearish to Bullish on GameStop

A few days ago, I warned OptionSmith newsletter subscribers that I was eyeballing a bearish position in GameStop (NYSE:GME) ahead of the video game retailer’s earnings report. Both regular and casual readers know that I’m a long-term bear on this company, though I have both profited and been gored in various short positions over the past year. This time, I was jacked up for a gap down.

The business model of physical stores that depend on used game sales and trade-ins for the bulk of their revenue is going the way of the dodo bird, or suffering a worse fate than Blockbuster. This past May, Microsoft (NASDAQ:MSFT) introduced a new Xbox and stated new games for the console could only be bought digitally. This is a big blow to the trade-in-and-up GameStop model. The stock tanked, and I had a bear position salvaged. But two days later, Sony (NYSE:SNE) introduced its new Playstation, which had no such restrictions on game trade-ins and also has a lower price point. Mr. Softee quickly reversed its stance. Gamestop shares proceeded to power up some 52% over the next three months.

So now, here I was thinking this a great, higher entry point to establish a fresh short. So I slap the title of “Bearish Earnings Play in Gamestop” and stop typing after hitting all the usual metrics, figuring they will fit into my thesis.

Estimates for both the top and the bottom line have come down sharply.

A bearish sign, right?

No. Negativity is now built in, and it will be easy to beat lowered expectations.

Revenues are going to show a year-over-year AND sequential decline. Terrible, right? Maybe not because both Sony’s and Microsoft's new consoles won’t be delivered until the fall along with all their accompanying new games.This gave management a chance to potentially provide some very positive forward guidance.

The stock recently has also been helped by a massive short base. Over the past year, short interest has run around 23%-29% of the float. These are the smart folks, and when one day they will be right. I used to belong to this group at a 12% lower price. Now I’m just someone trying to figure out what’s going on. What I do know is that in the short-term, a better-than-expected report will force shorts to become panic buyers, providing fuel for a price spike. I generally don’t want to be on the short side of a heavily borrowed stock ahead of earnings. The potential for a short squeeze is just too high.

While I know an earnings report can turn a chart immediately, GameStop did look relatively constructive with a nice bull flag forming after the recent breakout.

And finally, I'm tipping my hat to Andrew Keene of Keene On Options, who has consistently reminded me to always look for unusual activity. Yesterday, the August $50 calls, which expire tomorrow, experienced a surge in buying, with some 1,500 contracts traded against prior open interest of just 201. Granted, these were done on 10-to-20 contract transactions rather than an institutional block, but it was just one more piece of the puzzle that tilted bullish. So I changed the title of the alert from Bearish to Bullish.

You can read the original alert here. We exited the position this morning.

The lesson is that you shouldn't let your preconceptions prevent you from keeping an open mind and doing the research needed for any new position, even when you think you already know the story.